How to Solve the Risk Hedge Problem in Options

Every trader faces the struggle of creating profits while reducing losses. With options, swing trading is one method for creating short-term exposure, but even then the risk problem is not resolved, writes Michael Thomsett of ThomsettOptions.com.

The purpose to swing trading is not to take a position in the market but to maximize trading gains while reducing losses. I have found one solution that I have tried out several times. I call this the "hedge matrix."

The strategy is based on opening what I call the 1-2-3 iron butterfly. It has several components. The iron butterfly is one of those strategies designed to limit maximum losses and gains. It consists of opening long OTM puts and calls and offsetting these with ATM short puts and calls. In the typical iron butterfly, three strike and four contracts are involved. For example, if the ATM is 45, you may open a long 42.50 put, a long 47.50 call, a short 45 put and a short 45 call.

This iron butterfly is attractive to many traders, but expanding it into a 1-2-3 iron butterfly creates a very interesting hedge.

The 1-2-3 iron butterfly has three different sets of butterflies, one in each of the next three expiration months. The ideal time to open this is right after ex-dividend date, to avoid early exercise of any ITM calls. Or if you open this on underlyings that don't pay dividends, that problem is avoided altogether. The first and third months are iron butterflies like the one described above, and the middle is a reverse iron butterfly. So the lower put and higher call are short, and the ATM contracts are long. This one creates a net debit.

The 1-2-3 refers not only to the three expirations, but also to the number of contracts involved. The first month uses one option at each position; the second (reverse 1-2-3) uses two of each; and the third uses three of each. Why do this? By increasing the number of contracts, you augment the net credit upon closing positions. A higher number of contracts in later months creates a desirable relationship due to higher time value, notably in those short positions. So closing one long this month versus two shorts next month is going to be easier to do with a net profit and a net credit.

The hedge matrix comes into the picture and makes the 1-2-3 such a strong idea. Every short position is covered by a later-expiring long position at the same strike. And every long position is offset by a later-expiring short position at the same strike. This means that matching up winning and losing positions and then closing them is easy and flexible.

In this strategy you want to maintain a balance between short and long in order to avoid creating unintentional risk exposure. So any time you close a long contract, you need to also close a short. Based on movement in the underlying, this often means matching up a short put with a long call, or a short call with a long put. Closing matched positions can be accomplished in three ways, and this is what the hedge matrix defines. They can be closed vertically (same expiration, different strikes); horizontally (same strike, different expirations); or diagonally (different strikes and different expirations).

You will also want to track the overall net credit or debit in the 1-2-3 iron butterfly. The original set-up creates an overall net credit, but if you close more short positions than long positions, it may move the overall into a net debit. But as long as the end result turns out profitably, the system works.

So what happens to those orphan options invariably left over? The original set-up has 12 positions and strikes, so at some point you are going to end up with three or four still open, probably in a loss position. You can close these at a loss as long as the overall remains profitable. Or, as I prefer, you can use these as a starting point for a reconstituted 1-2-3 iron butterfly using more expirations and different strikes based on how the underlying may have shifted.